With Inflation Falling, Why Aren’t Treasury Yields Falling As Well?

Posted by Lawrence Gillum, CFA, Chief Fixed Income Strategist

Wednesday, August 16, 2023

Last week’s release of the Consumer Price Index (CPI) was the second month in a row that showed inflationary pressures were falling at a faster pace than economists’ estimates, which is undoubtedly good news. Additionally, the fall in inflationary pressures likely means the Federal Reserve (Fed) is close to the end of its aggressive rate hiking campaign, which we outlined in our recent Midyear Outlook, has historically been good news for core fixed income investors. So why haven’t Treasury yields fallen (prices increase) alongside the fall in inflationary pressures? The main reasons, in our view, are listed below:

  • Supply/Demand Imbalance: Because of larger than expected budget deficits, the Treasury department announced recently that it seeks to borrow an additional $1 trillion in the third quarter alone (and nearly $2 trillion over the rest of the year). This is on top of the $1 trillion of new debt that has been issued since the debt ceiling was removed in June. The increase in supply is coming at a time when the largest owner of Treasury securities (the Fed) is reducing its footprint in the market.
  • Non-U.S. Central Banks: While inflationary pressures are indeed falling in the U.S., the Eurozone and the United Kingdom are dealing with still elevated inflationary pressures. As such, those respective central banks are likely not done raising interest rates. Moreover, the Bank of Japan (BOJ) recently announced it would “conduct yield curve control with greater flexibility”. Essentially, this means the BOJ will allow the yield on the 10-year government bond to increase by another 0.50%. Higher yields on non-U.S. domestic government bonds impact U.S. Treasury yields, to certain degrees, as well.
  • Better U.S. Economic Data: As evidenced by the inverted yield curve (chart below), the U.S. Treasury market has been pricing in an economic slowdown for several quarters now. However, economic data continues to surprise to the upside. The continued strength of the U.S. economy, in spite of one of the most aggressive Fed rate hiking campaigns in decades, has caused the bond market to start to price out the immediate risk of recession. Moreover, it is pricing out the immediacy of interest rate cuts as well. The higher-for-longer narrative by the Fed has put upward pressure on intermediate and long-term yields. Historically, these “bear steepener” trades don’t tend to last very long, but as long as the U.S. economy outperforms expectations we could continue to see upward pressure on intermediate and longer-term yields.

View enlarged chart

Our base case remains that the U.S. economy will slow down/contract due to the elevated interest rates caused by the Fed rate hiking campaign. So, while we still think the 10-year yield ends the year lower, as long as economic data continues to surprise to the upside, Treasury yields may remain above our 3.25%–3.75% target range in the interim. However, it’s important to remember that, over time, starting yields are the best expectation of future returns and that the coupon income, and not price appreciation, is the largest determinant of total returns regardless of what happens to interest rates in the near term. And with starting yields for most fixed income markets well above longer-term averages, we think the prospects for fixed income are as attractive as they have been in quite some time.


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